Network Externalities and the “New Economy”

A central idea in much of the New Economy thinking is the idea that
certain new products being produced today increase in value as more people
use them. A familiar example is the internet. If you are the only one with
an internet connection, it isn’t worth very much since there are no others
to email with or any web sites to visit. As the network expands, and friends,
family and amazon.com get connected to the internet, the connection becomes
more and more valuable. These effects have been termed “network externalities”,
and they may have important effects on the workings of the economy.

The term “externalities” refers to the indirect effects that one user
has on the other users of the same network. For example, when you link
up to the internet, you are indirectly increasing the value everyone else’s
connection since they can now send you email.

This idea is also linked to a related idea typically called “path dependence”.
If the value of a product in question grows with usage, then it pays to
be big. If a product, for any reason whatsoever – including historical
accident – gets enough users early on, then the product may be favored
over others of higher “innate” quality just because it was there first
and has an established user base.

The typical (but misleading*) example here is
the competition between VHS and Beta VCR’s. As VHS initially gained a majority
of users, it became a more valuable product simply because others used
it (for example you were more likely to be able to trade tapes with friends
if you had a VHS). Path dependence is then the idea that the current dominance
of VHS, over a technologically superior Beta format, is a result of a simple
historical accident. If BETA had an initial lead it too could have taken
over the market.

Similar examples could be made with other high-tech products like Microsoft’s
Windows operating system. The role of network externalities is also playing
a central role in the war over internet browsers and modem protocols –
the players in the market know that whoever gets biggest fastest will probably
end up dominating the market.

Is this a really a new feature of the Economy?

Not really.

There have always been networks and network externalities associated
with products in the economy. The telephone network as well as the railroad
and interstate “networks”, to take three large examples, are not exactly
new.

The important question is whether or not the new economy is producing
relatively more of these products than in the past. Casual observation
suggests that they may be taking on a more important role, since high-tech
industries often display some of the characteristics needed to generate
network externalities.

What do the changes mean for the economy?

As the economy shifts to the production of network related products
we must also ask ourselves what this implies about the working of the economy
and what kind of policy the government should pursue.

The first important issue to consider is market structure. If network
externalities imply that bigger is better, then more and more “natural
monopolies” will arise. Consider the case of Microsoft’s dominance of the
operating system market. As MS Windows took over the OS market, in part
due to the presence of network externalities, Microsoft became virtually
a monopoly producer of computer operating systems.

We are used to thinking that monopolies are bad – since they often have
the ability to raise prices and extract monopoly rents from consumers which
may then lead to inefficient levels of production. However, in the case
of a “natural” monopoly, we would like to have only one producer since
this is the best way to efficiently produce the product. One way to deal
with this problem is to have the government run things – by outright ownership
or heavy regulation – as in the case of the post office or the phone and
cable industries pre- deregulation.

If government ownership or heavy regulation isn’t a practical option
then what? Answering this question will be a major policy challenge for
the new economy.

* The VHS-BETA example is perhaps the second
most common story used to illustrate path dependence (the first most common
being the QWERTY keyboard). It is slightly misleading in that the two technologies
were not exactly the same except for a historical “accident” or two. First,
despite slightly lower picture quality, VHS had a longer running time of
2 hours meaning that it could comfortably hold most movies on one tape
– so the choice of VHS may be more than just a historical accident. Also,
other factors such as pricing policies and licensing strategies may play
important roles in determining the ultimate winner. See Economides’ Letter
to the Wall Street Journal on Path
Dependence for more.